Weathering the Storm

Referring to the recent developments in the stock market as unpleasant is like referring to the Japanese attack on Pearl Harbor as unpleasant. This is as rough and volatile a ride as I’ve seen in 25 years. The S&P 500 is down 18% in a few weeks. It is akin to autumn 2008 in that there are fears of a contagion that we don’t quite understand, coupled with hurried responses from central bankers and elected officials that indicate they’re not sure of the appropriate next steps either.

The media have been calling several times a day asking breathless, passionate questions about what I think is going on, and what will happen next. Crises are good for media outlets. It’s tough to garner much interest in the weather report on calm, balmy days. But the media attention exacerbates the anxieties.

While the keenest interest seems to be in which direction and to what extent the markets may move in the next 20 minutes, I’d like to offer a more broad perspective. I don’t have any idea what the markets may do today or tomorrow or this week or next. I never do. Short-term markets are irrational, and there’s no better evidence than our current experience. However, it is hard to believe that the intrinsic value of some of the greatest companies on the planet really dropped by 20-25% in the past few weeks.

Over the long term, share prices behave somewhat predictably: they are affected by the performance and financial well-being of the actual companies for which they represent ownership. If one owns shares in a dynamic, well-managed and growing company, one will see the value of those shares increase. This is not to say that we are sounding the “all clear” signal. Markets could definitely head lower before things improve. However, there are plenty of reasons for optimism, and these reasons sometimes get forgotten during times of panic.

So given that we don’t know where the market is going over the near term, let’s review what we do know:

U.S. government bonds, AAA or no AAA, are still considered to be the safest place in the world to park money. The U.S. government could borrow money for 10 years at 2.56% before the downgrade. Today, it can borrow money for 10 years at 2.15%. The U.S. has problems, but the world has not given up on us.

U.S. multi-national corporations are in great financial shape. Cash balances are near all-time highs. These companies are able to borrow (though most don’t need to borrow) at ridiculously low interest rates. Profit margins are near all-time highs. None of these things have changed over the past two weeks.

U.S. banks are in better shape than they were two years ago. They have raised an enormous amount of capital. Balance sheets are in better shape as measured by a wide variety of capital ratios. Banks are no longer willing to make the stupid loans that they routinely made 3-5 years ago. Housing prices remain weak but are already down 35%. We don’t see any reason that housing should suddenly get better but it seems logical to assume that the worst is probably behind us at this point after a horrific drop. U.S. bank stocks now trade, in most cases, at less than their book value.

U.S. stocks, on the whole, are not statistically expensive. The PE ratio on the S&P 500 is about 12x. This compares favorably to the long-run average PE of about 15x. It compares VERY favorably to the roughly 25x multiple awarded to company shares back in 2000. Future returns for an asset will be determined, in large part, by the current valuation level of that asset. Statistically, stocks look very good vs. bonds. The earnings-to-price yield on the S&P500 (e.g. the inverse of the PE ratio) is currently 8.3%. This compares favorably to the 2.15% return that an investor could lock in for 10 years by buying a 10 year treasury at current levels.

The current market maelstrom continues to rage in full force, and make no mistake, this is a serious storm. I doubt that it will be THE STORM to end all storms. In a really bad storm, intelligent people seek shelter, they don’t panic, and they wait for it to pass. There are always those who dash around frantically, mewing and gasping, perversely delighting in the delicious dramatic moment. But they, like high school girls weeping over the break-up of the quarterback and prom queen, are not to be taken seriously.

What I know about the market’s action at present is that its general trend is down and that volatility is intense. I know that trends last longer than people expect. This current trend, in my opinion, is a continuation of the 2008 downturn. World economies and markets are continuing to respond and react to years of profligate spending and profound over-dependence on credit. These excesses, no matter how one would like to criticize how ill-considered they were, were huge, and they will take a lot of time and pain to repair.

The good news is that reconstruction is underway. Economies cannot begin the process of expansion (no matter how desperately desired) until they have completed the process of contraction. While I’m encouraged by the drop in oil prices, very low interest rates, strong earnings reports and strong corporate balance sheets; no fundamental turn is possible until fundamental demand returns. Fundamental demand means that people have both the means and desire to purchase goods and services. The US consumer has accumulated double the amount of debt he had in 1980 (relative to income), has a bad job market to contend with, and is seeing the prices of things increase. While the American desire to spend seems to beat like life-force in American chests, the means are simply not there and will take time to return.

Passenger vessel captains know that storms are part of their jobs. Investment managers know the same thing. Our choice has always been for the more stable, defensive vessel and the calmer course. We’d rather take a day or two longer to reach our destination than put our vessel or passengers in jeopardy.

Ignore the noise. In deference to my wonderful friends at CNBC, I won’t tell you to turn off your televisions, but please hit the mute buttons. The current hysteria WILL NOT help your investment returns. Part of being a long-term investor is going through horrible periods like this one. Warren Buffet has come through countless horrible periods. These are the trials by which successful investors earn their stripes. Unless this really proves to be the end of the world, it will pass.

I believe that America continues to be the best environment in the world to reward and protect innovation and growth. As America navigates her way through yet another crisis, she will emerge stronger, and her people and corporations will be renewed and flourish. Corporate America will expand. Investors with the stomach and tenacity to endure the volatility will enjoy the fruits of their long-term investments.

Hang in there. We will reach our destination together. Don’t hesitate to call us for a little hand holding and stock-talk if we can help.

2017 Awards

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